Securities Market Regulation and Private Equity Placements in China

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1 Securities Market Regulation and Private Equity s in China Nathan Dong 1 Ming Gu 2 Hua He 3 1 Columbia University 2 Renmin University of China 3 Cheung Kong Graduate School of Business September 15, / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

2 The biggest drop in Chinese stocks in eight years Monday is another sign that Beijing s efforts to prop up prices have failed. Moreover, the interventions themselves have made China s equity markets more volatile and damaged their credibility in the long run. The Wall Street Journal July 27th, / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

3 The biggest drop in Chinese stocks in eight years Monday is another sign that Beijing s efforts to prop up prices have failed. Moreover, the interventions themselves have made China s equity markets more volatile and damaged their credibility in the long run. The Chinese government s proper role is to eliminate accounting The fraud, Wall Street encourage Journal better corporate governance, andjuly require 27th, 2015 full and fair disclosure. Burton G. Malkiel Author of A Random Walk Down Wall Street 3 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

4 Equity market regulation Equity investors are subject to the risk that stock issuers will sell bad securities to the public (La Porta et al. 2006) The appropriate level of regulatory requirement can reduce information asymmetry (Carpentier et al. 2012) The objective is to promote fairness, prevent abuse, eliminate mispricing, and enhance firm value 4 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

5 Facts in developed countries Commonly believed that the market outcome without government intervention, at least in most circumstances, is efficient (Tobin 1982) The apparent periodic failure of stock markets is often used to justify the remedial introduction of market regulation (Ramano 1998; Daniel, Hirshleifer & Subrahmanyam 1998) 5 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

6 Private equity placement (PEP) Non-underwritten stock offering sold directly to a small group of investors Exempt from registration with the SEC The lack of regulatory oversight and disclosure reduces the refinancing cost and saves time and auditing resources. Information about PEP transactions are limited 6 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

7 Challenges in China Financial market is underdeveloped Highly state-controlled Seeks to promote economic development Private placement of equity has shorter history and more strict regulation On May 8, 2006, China Securities Regulatory Commission (CSRC) issued The Administration of the Issuance of Securities by Listed Companies Regulatory approval Limited number of participants Different lock-in periods 7 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

8 8 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

9 Previous Studies Private placements have market discounts Wruck (1989); Hertzel and Smith (1993), Chen et al. (2002), Wu et al. (2005) Positive announcement effects Hertzel and Smith (1993), Kato and Schallheim (1993), Krishnamurthy et al. (2005), Renneboog et al. (2007), Lu et al. (2011), Fonseka et al. (2014) The literature attributes the discounts and abnormal announcement returns of private placements to Monitoring effect: Wruck (1989) Certification effect: Hertzel & Smith (1993) Managerial entrenchment: Barclay et al. (2007) Investor over-optimism: Hertzel et al. (2002) 9 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

10 Previous Studies Long-term underperformance of private equity placements firms are documented in US Market: Hertzel et al. (2002), Krishnamurthy et al. (2005), Barclay et al. (2007), Brophy et al. (2009), and Chen el at. (2010) Japan Market: Kang et al. (1999) However, they are inconsistent with underreaction hypothesis in Daniel et al. (1998) Investors overreact to private information signals due to overconfidence and underreact to public information signals 10 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

11 Research questions Does the stringent regulation in equity issuance in China has an impact, good or bad, on market participants in a long term? Are the short- and long-term effects of private placements in China similar to those in the developed countries? Who actually benefit from them? 11 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

12 PEP issuing firms perform better than non-issuing firms following private placements in both short- and long-term The perceived and real effects of monitoring and certification Long-term abnormal returns to all shareholders are higher if controlling shareholders participate in PEPs The active role of large investors to exert governance and urge better performance Long-term operating performance improves when controlling shareholders participate in PEPs Participating investors who are best informed and positioned to monitor are likely to be approved 12 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

13 We compare firms issuing PEPs with those not issuing PEPs over the same time: event study and BHAR All A-share listed firms that had private equity placements between 2006 and 2012 from the Wind Dataset 580 firm-year observations (544 firms) that have successfully completed PEPs Financial accounting information from China Stock Market Accounting Research (CSMAR) Identifying control firms based on size and BM, and measuring long-run returns (Krishnamurthy et al. 2005) Classifying 108 observations as the PEPs bought only by controlling shareholders of the issuing firms or any other firm controlled by the controlling shareholders, based on investor identity information from RESSET 13 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

14 Sample Selection 14 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

15 Industry Breakdown 15 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

16 Short-term Returns 16 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

17 Short-term Returns 17 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

18 Short-term Returns by Participant Type The market may view the PEPs to controlling shareholders as a better signal (monitoring effect of Wruck 1989 and certification effect of Hertzel and Smith 1993), although there might exist potential insider self-dealing in the form of deeper discounts to controlling shareholders investors 18 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

19 Size and BM-adjusted Long-term Returns The participating investor returns are calculated by compounding the non-participating investor returns and the returns from the offer price to the closing price of the announcement day 19 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

20 Size and BM-adjusted Long-term Returns The participating investor returns are calculated by compounding the non-participating investor returns and the returns from the offer price to the closing price of the announcement day 20 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

21 Long-term Abnormal Returns by Participant Type Long-term returns to all investors with controlling shareholders participation are higher than the returns without their participation 21 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

22 Participation Effect of Controlling Shareholder Cross-sectional evidence that long-term returns to all investors with controlling shareholders participation are higher than the returns without their participation 22 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

23 Improvement in Operating Performance after PEPs 23 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

24 PEPs in China are different in many respects from those in other countries (both developed and developing) Requiring regulatory approval Limited number of participating investors Different lock-in periods for different investor categories Economic significance Both short- and long-term abnormal returns following private equity placements Participating shareholders benefit more from long-term returns than other shareholders General investors benefited more when controlling shareholders participate in the placements Operating performance improved after the PEPs 24 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016

25 PEPs in China are different in many respects from those in other countries (both The objective developedofand regulation is developing) to promote Requiring regulatory approval Fairness Limited number of participating Prevent investors abuse Different lock-in periods for different Eliminate investor mispricing categories Economic significance Enhance firm value Both short- and long-term abnormal returns following private equity placements Participating shareholders benefit more from long-term returns than other shareholders General investors benefited more when controlling shareholders participate in the placements Operating performance improved after the PEPs 25 / 25 Conference on China s Financial Markets and the Global Economy Bank of Finland 2016